This stock deserves its lumps of coal

Commentary: Digging into Arch Coal unearths no diamonds

BOSTON (MarketWatch) — While it may be possible, technically, for coal to become diamonds, it doesn’t work that way. Both diamonds and coal are made from carbon, but diamonds are created at depths far below where coal is found.

Likewise, in investing, a lot of people look at the coal business as a diamond in the rough — a recession-proof industry that offers stability, consistent demand (thanks to laws that encourage the use of “clean coal”), and a history of profits.

For average investors who want to diversify their energy and utility holdings with a coal play, Arch Coal Inc.
ACI, +0.92%
has the attractive earmarks: reasonable stock valuation, a dividend yield above 3%, growing sales and all of the plusses of being an energy supplier.

Mine the data deeper and you’ll see that this stock is no diamond in the rough, but it is the Stupid Investment of the Week.

Stupid Investment of the Week highlights the conditions and characteristics that make a specific security less than ideal for average investors, in the hope that spotlighting danger in one situation will make it easier to root out trouble elsewhere. The column is not intended to be an automatic sell signal, especially in the case of Arch Coal, where an investor with a long lens on the market and a lot of patience could be rewarded.

Into the mines

The problem with Arch Coal — the nation’s second-largest coal producer — is that what looks attractive to the average investor is a bit of a mirage. The valuation and dividend yield look good in part because the stock got hammered last year, losing 57% of its value in 2011. That brings out bargain hunters thinking the company hasn’t got much further to fall, and hoping that a recovery to most fair-value estimates would result in a quick gain of 20% to 33%.

Unfortunately, a closer look at the numbers suggests that 2012 will be another rough year for the company, and that 2013 might not be much better. So even if the stock has the long-term potential for growth, the timing is wrong.

St. Louis-based Arch Coal has a volatile performance history — in the last decade, it has had five years with gains north of 38%, and three years with losses south of 22% — that reflects a bit of its own volatile strategy. In 2005, Arch sold most of its Central Appalachian operations — getting rid of costly legacy liabilities in the process — but then turned around and purchased International Coal Group, putting it squarely back into the region, but now with a balance sheet that was heavily leveraged to get the deal done.

The balance sheet is a major concern, because it makes the company a bit more subject to the whims of the economy. That’s particularly true where the strategy of acquiring International Coal Group is involved, since that company was purchased largely because of its resources in the metallurgical coal business; metallurgical coal is a commodity where the price is heavily dependent on economic conditions in China, which could weigh on the company in the near term.

Further, U.S. coal prices currently are weak, and could be dramatically affected by how the government decides to regulate the business — something industry insiders say could change depending on who wins the White House later this year.

Sooty prospects

Arch Coal has strong sales commitments for 2012 — and its low-cost operations should ensure that it’s at least coming close to guidance levels — but a quick look at the market could make some rethink their idea that coal is recession-proof; at the very least, it will make them recognize that coal is a commodity business, subject to all of the swings inherent to that description.

Metallurgical coal prices are off by more than 30% from peak levels in 2011, and record-low prices for natural gas are hurting a lot of coal producers, but particularly the ones with exposure to Central Appalachia because coal from that region is not price-competitive with gas.

Further, the mild winter is only beginning to have its impact on the coal business; suffice it to say that there’s a lot of spare inventory that might have been used under worse weather conditions. That excess supply will affect prices for at least the rest of this year. (Those low gas prices might get an average investor to look at gas stocks, rather than coal miners.)

Put those things together and it’s clear why analysts seem to hate Arch Coal right now.

David Brown, chief market strategist for Sabrient Systems Inc., noted that in the past month 90% of the analysts following Arch have lowered their estimates for the next quarter and/or next year, with much of the worry being the “aggressive accounting” on that stretched balance sheet. He rated the stock, at best, as a hold, which means he thinks more of it than most.

Roger Conrad, of Roger Conrad’s Utility Forecaster newsletter, noted that an investor looking to the coal industry would be better off trying not to find everything they want in one stock, using Arch both for dividends and potential price appreciation. Instead, he suggested industry leader Peabody Energy
BTU, -0.96%
for growth and Penn Virginia Resource Partners
PVR, -3.95%
for yield.

Ultimately, investors looking toward Arch — and coal in general — may be rewarded, but only if they can stay patient and suffer through 2012-13. In the meantime, they will feel the pressure and heat, and their coal still won’t investment still won’t turn into diamonds.

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